Forex Options: Mechanics and Pricing
The way Forex options work and their pricing is an important thing for any Forex trader to understand. Exercising your options is not the only way you can profit from them; options writers may issue their own options, but holders could potentially sell them to third parties. By closing their positions, holders can not only eliminate their exposure by getting their money back, they could make a profit, if the price of option has changed in the meantime or at least cut their losses.
The hard truth about Forex options
Nowadays, very few Forex options are actually exercised, and options on Forex markets are no exception. Some estimates place the number of exercised options around 10%, whereas up to 60% get re-sold to third parties or back to the writers after a while. The rest expire worthless. The truth is, most holders are aiming to close as early as possible and net themselves a nice, quiet profit rather than wait and risk. You see, in order for an option to be worth your while (if exercised in the ‘traditional’ way), the price of the underlying instrument (in this case, currency) would have to be large (or small) enough to cover the premium you paid, plus the amount you need to buy the instrument, plus any additional expenses like commissions, etc. And you need to consider that options are typically sold in bulk, so if you wish an option to buy 100 units of some currency, the premium is paid for each one of them. If the premium for an option on an instrument is $2,50 in order to buy 100 units you’d need $250 just for the premium. The fact is, price changes are rarely that large and people usually wait for the price of the option to increase so they can sell them and make a profit. So the price of an instrument may not rise or fall as much as you’d hoped for, but any changes will result in similar changes in the value of the option. That same option could be worth $3,25 the next day, and selling it would not only cover your losses but net you $75 without breaking a sweat. Naturally, Forex enables you to do this on a much larger scale, so the possibilities for profit are limitless. This example is purely theoretical, in order to illustrate the way options work.
Pricing
When first acquired, Forex options only have basic, intrinsic value. In time, they get a time value, which could be negative or positive. When combined, you get the premium. So, an option whose price rose from $2,50 to $3,75 had an intrinsic value of, say, $3,50 and a time value of $0,25 for the price of $3,75. The ‘time value’ expresses the possibility of a favorable price change (from a holder’s perspective), whereas the intrinsic value is the amount you’d get if you exercised the option on the spot. There are other factors, but their influence is minor. For lengthier explanation, please click here.
